Overseas Sales Risk: the Drain on Working Capital

Selling internationally can tie up large amounts of capital, but there are ways to minimize the impact.Scott Bergquist, CFO.com | USApril 10, 2012

Are you ready to sell abroad? All new sales have an impact on working capital, but overseas sales even more so. As you expand into new markets it is important to understand the unique considerations of selling internationally.

Generally speaking, increasing product sales puts demands on a company's liquidity position. Cash is tied up in paying vendors for materials, employees for building widgets, sales teams for selling, and channels for distributing, all in advance of customer payments.

When international sales rise at a double-digit pace, a classic conundrum for small businesses or start-ups gaining traction, companies can drain their liquidity (cash and borrowing availability) to threatening levels. While CFOs may cheer the orders flooding in, they have to be thoughtful to avoid surprises, particularly when sales are happening overseas. Prior to earning significant revenues outside the United States, a company has to address several potential problems, as described below.

Extended TermsThe typical "net 30" terms will not likely apply to overseas transactions, because, given logistics, such a short time frame is seldom practical. Accordingly, extended "open" terms (see below) are the norm for creditworthy buyers and anxious sellers. Simply put, extended payment terms tie up the seller's liquidity in the system longer, which can constrain its ability to finance new inventory, sales, etc. So the CFO has to be sure to measure liquidity assuming replenishment could or will be delayed beyond the terms typical for domestic sales.

Unknown BuyersForeign buyers are often first-time customers and unknown to sellers. Open terms, where the customer can buy on credit as long as it continues to pay regularly, can be a challenge, because the seller is reluctant to ship product prior to payment, and the buyer is unwilling to pay in advance of receipt. International trade professionals long ago (centuries!) solved the dilemma with a trade letter of credit, whereby a financial institution acted as intermediary to substantiate that goods or a service had been received before releasing payment.

Letters of credit (LCs) are not only an effective way to mitigate risk, but they help manage working capital needs as well. Since the maturity (payment) dates of LCs are certain (assuming the seller performs), cash flows are predictable. In addition, there are ways to accelerate payment under long-term LCs through discounting. In this case, the seller's bank pays the seller today at a discount to the LC's face value, and then the bank receives full payment upon maturity. Of course, this presumes a strong bank relationship and historical contract performance.

Unstable CurrenciesWhether pricing in local or U.S. currency, a transaction is subject to foreign-exchange-rate fluctuations. This is important because any surprises regarding what the seller expects to be paid will have an impact on its liquidity and working capital availability. Let's say a company just sold 1,000 widgets at $100 per unit, for a total invoice of $100,000. If the gross profit margin is $15,000, a 5% currency swing on the total invoice could wipe out one-third of the company's profit. This may be less of an issue for a software company with 80% to 90% gross profit margins, but not for more commoditized products with lower margins.

There are really only two ways to address currency risk: assume a currency hedge or match payables to the receivables currency. A currency hedge is a common transaction to lock in currency value in advance of receipt. Knowing the seller will receive 10,000 euros in 30 days, its bank would enter into a contract to sell the currency at a price 30 days forward. Thus the seller will know exactly what it will be paid regardless of fluctuations, protecting gross profit margin and liquidity. Matching payables to receivables implies that expenses for things like a sales team or a distributor or vendor relationship are incurred in the same local currency as sales. This is also called a natural hedge.

Borrowing ExceptionMany businesses utilize working capital lines of credit to help manage the cash conversion cycle. Since cash is tied up in sales and production well in advance of invoice payments, a line of credit can provide liquidity today and be repaid with proceeds. In a simple advance formula, a bank might lend against 80% of eligible invoices. Often, eligibility is limited to domestic receivables, however, thus no advances for a company's new launch into Europe and Asia. This is a double whammy: more cash is invested in growing sales and production overseas, and the payments schedule will likely be extended.

Still, there are a few ways to expand borrowing availability commensurate with international sales:

Work with a banker to include the most creditworthy foreign buyers.

Sell with the protection of LCs (using an effective LC discounting program, if suitable).

Buy trade credit insurance to protect against nonpayment.

Encourage a banker to explore an enhancement from the Export-Import Bank of the United States, a government agency established to promote U.S. trade and job growth.

Selling products internationally can be a daunting proposition, but doesn't have to be. Bankers and other professionals can give advice on how to grow sales — without putting the company's profit margin or liquidity position at risk.

Scott Bergquist is the central U.S. division manager for Silicon Valley Bank, overseeing business development and client relationship activities with 2,000 companies and managing more than $1 billion in committed capital. He specializes in unique financing solutions for high-growth technology and life-science companies.